In the second quarter of 2021, the commercial real estate market in the U.S. totaled $20.7 trillion with multi-family, office and retail ranking highest in value.
But how are these values determined?
In commercial real estate there are multiple methods for valuing property. It can be overwhelming to determine the right method to use for your property and how to properly apply it, but you absolutely can learn how.
In this series of blogs, you’ll learn about the top three methods for determining the market value of commercial real estate.
Commercial Real Estate Market Value Methods
Investing in commercial real estate is a process of mitigating risks and projecting returns. Real estate investing can be an excellent addition to your investment portfolio because it is less vulnerable to market fluctuations and generally increases in value over time, particularly when it achieves its highest and best use.
When investing in commercial real estate you may use one of three approaches to determine its market value – income capitalization, sales comparison and cost-depreciation.
These approaches are appropriate in many situations; however, particular circumstances may require a unique or combination approach. Consult a trusted advisor to help you determine the best approach for your particular situation.
Income Capitalization Approach
In this blog we will explore the income capitalization approach, the most common for appraising income-producing commercial real estate.
This method is used to estimate the value of a property based on the income you expect the property to generate. Follow along as we walk through the steps involved in the income capitalization approach.
Ultimately the income capitalization approach finds a property’s value by dividing the annual net operating income (NOI) by the desired capitalization rate. NOI is equal to gross income less operating expenses, exclusive of debt and interest payments.
Start with an annual operating statement that finds potential gross income (PGI) – assuming 100% occupancy. Subtract from PGI any vacancy and collection losses (unrented space and uncollectible rents). Then add any other income, like vending and coin operated laundry machines, parking fees, etc.
This gives you effective gross income (EGI), from which you subtract annual operating expenses:
- fixed expenses – real estate taxes & insurance
- variable expenses – maintenance and utilities provided by owner
- replacement reserves – for appliances, fixtures, etc.
Following this formula will determine the Net Operating Income, which is then divided by the capitalization rate to determine the property’s value.
The capitalization rate (cap rate) is calculated by dividing the NOI by the property’s total value. Cap rates are also often found by comparing other similar sold properties to their net income.
To choose a cap rate you will need to analyze sales of comparable properties and their expected cap rates. The more data you can collect and confirm, the better. Your valuation will only be as good as your assumptions for the NOI and cap rate.
Why value matters
An accurate valuation of property is important because it affects other elements of property ownership. For example, a property’s value impacts the considerations given by mortgage companies, investors and insurers. An accurate valuation may even lead to righting a tax assessment.
Begin Investing Today
Now that you have an idea of how to find commercial real estate market value, and how important an accurate valuation is, you can continue your real estate investment journey. We can help guide you through the process, contact us today!